Standard Life Investments, the global investment manager, believes that a lengthy period of Quantitative Easing (QE) is needed to support economies through years of fiscal tightening and debt de-leveraging.
Despite the short term nature of the stimulus which QE provides to financial markets, investors should be aware of the risks of mis-timing the withdrawal of QE.
In the latest edition of Global Perspectives the leading investment house examines how QE buys time, during which economies can restructure, but shows that it does not solve the underlying problems in countries facing major imbalances. The report highlights the downside risks, both during its operation and when QE begins to be withdrawn.
It is generally agreed that QE is a blunt instrument. It can create confidence and buy time, but it will not solve the underlying difficulties caused by the long lasting debt deleveraging process. Although technically there is no limit on the expansion of a central bank's balance sheet, in practice there are constraints - QE is not a costless exercise.
There is some evidence that successive rounds of QE have a decreasing impact on financial markets. Eventually central banks could incur serious losses on their holdings; for example, there are concerns that European central banks may need recapitalisation if large losses are incurred on holdings of peripheral government bonds. It should also be noted that the distortions to sovereign and corporate bond yields has had a material impact on pension schemes. Lower annuity rates in the UK would be an example of the adverse effects of QE on pensioner incomes.
Andrew Milligan, Head of Global Strategy, Standard Life Investments said:
"There will be major risks when QE is halted or withdrawn. At some point, central banks could announce the end of QE, potentially causing a major sell-off in government bonds with much higher yields - akin to the bond crisis seen back in 1994. Withdrawal could cause other difficulties; do central banks allow their stock of debt to mature or do they begin to sell back into the marketplace, exacerbating the effects of any interest rate changes? As the timing of QE announcements has periodically caused currencies to depreciate, then the timing of QE withdrawal will presumably have an impact on relative currency appreciation. The sensitivity is already clear; the latest FOMC minutes included a section about the future of QE, stating most participants saw no sales of securities beginning earlier than 2015."
Andrew concluded:
"QE can only buy time. Our analysis suggests that extra QE will remain a vital tool for central banks. This reflects the subdued nature of this economic recovery, with large amounts of spare capacity and a lengthy de-leveraging process. This is against a backdrop of difficult fiscal positions, meaning external shocks or the threat of a painful rise in borrowing costs or exchange rate appreciation could damage any moderate economic recovery. QE is an anaesthetic, and hence is useful, but mis-timing its withdrawal could be rather unpleasant."
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